When You Should or Should Not Max Out Your 401(k)

• Saving for retirement is a worthy endeavor and a financial task many people struggle with
• Contributing the max to a 401(k) plan is not the best move if you have a low salary, are struggling with cash flow, or have not thought about other savings vehicles
• Individuals in a high tax bracket with other financial goals already accomplished are well-positioned to max out their 401(k) plans

It’s common personal finance wisdom that you should contribute as much money as possible toward your retirement. After all, delaying gratification is often the name of the game when it comes to building your net worth. Moreover, the more money you sock away in a tax-advantaged account while investing in diversified, low-cost funds should, one day, lead to a prosperous retirement. But not everyone should focus so heavily on maxing out a 401(k) and not all circumstances warrant such a strategy. Let’s analyze when you should and should not contribute up to the limit in your employer-sponsored retirement plan.

401(k) Ground Rules

For background, most companies offer workers a low-cost 401(k) plan so they can save and invest for retirement. A regular 401(k) has the benefit of allowing you to contribute with pre-tax dollars, effectively giving yourself a current-year tax break. A Roth 401(k) is available to most people these days, and it features the opportunity to put after-tax dollars to work in the market. Also, a big benefit with most 401(k), 403(b), and 457 (b) plans is a company match. In almost all situations, it is indeed wise to contribute up to that matching percentage – often 50% of the first 6% of your yearly contributions.

How Much to Contribute? No Easy Answer.

Where it gets tricky, though, is determining the right amount to contribute to your 401(k) above the matching level. Sure, if you’re rolling in the dough and in a high tax bracket, then deferring the 2023 max of $22,500 ($30,000 for those age 50 and up) into your plan is often the right move.

When Not to Max Out A 401(k)

But there are situations in which you should be hesitant to do so. It takes a careful assessment of your current and future cash flow needs and an understanding of financial risks that could arise. If you earn, say, $50,000 per year, then stashing more than 40% of your salary into a 401(k) will almost certainly not make sense. Also, your company’s 401(k) plan may be too costly with a poor investment lineup. Be sure to review the account fees and mutual fund expense ratios to see if investing through an IRA is the optimal move.

For young workers who might job-hop, a plan’s vesting schedule might not even allow them to keep matching contributions. In general, while it is a noble goal to max out your 401(k) plan each year, if you are struggling to maintain a decent cash buffer (such as an emergency or rainy day fund) or might soon face a cash need, then absolutely do not feel bad about keeping your 401(k)-contribution percentage low.

It’s also conceivable that you are on a solid financial footing but simply have other priorities. Maybe you have high-interest debt that you are tackling. Perhaps you and your significant other plan to tie the knot in a few years and then buy your first home. Part of sound financial planning is knowing yourself and recognizing what goals mean the most to you.

We often see clients who contribute up to the match in their employer’s retirement plan while funding a Roth IRA and using the remaining money to build 529 savings accounts for their kids or simply to pay for everyday expenses. Your overall financial wellness is key – it’s not all about growing your 401(k) to the highest value possible.

When to Max Out a 401(k)

For some people, however, the right move is to reduce income tax as much as possible today through pre-tax 401(k) contributions. This generally applies to workers in high income tax brackets and who have already funded emergency savings accounts and other goals. For example, if you earn $225,000 annually, then contributing $22,500 equates to just a 10% savings rate – it is probable that you are still able to save elsewhere while still meeting all your financial obligations. Avoiding paying income tax at the 32% rate with plans to have a rate, say, of 22% in retirement is a winning strategy. (Of course, we do not know what future tax rates will be.)

Think About Today & Tomorrow

If you are ambitious enough to save to the max through your 401(k), be sure to consider the lifestyle you want now versus later in life. If you want your golden years to be simple – a paid-off house, some travel here and there, modest meals – then maybe you won’t even require such a big retirement account balance. In that case, spending a bit more today on loved ones and fun experiences should take priority. Here’s something you can do: Figure out how much money you want to spend each month in retirement then work backward to determine what you should invest each month in your 401(k). You might find that maxing out retirement savings is not the best use of money.

Financial Priorities to Tackle

It is no easy task to figure out if you should max out your 401(k), but there are some financial goals you should take care of first:

1. Build an emergency fund of cash to fund three to six months of living expenses
2. Eliminate high-interest debt
3. Consider near-term goals that may require a significant cash outlay
4. Check to make sure you have the right insurance coverage

Saving More Is Still Usually the Right Decision

This article is not a free pass to forget about funding your retirement. It’s simply meant to be an objective look at one of the most frequent questions asked in personal finance. And like so many answers to such questions, “it depends” is the correct response.

Unfortunately, 35% of Americans have next to nothing saved in an IRA, workplace plan, or other account types.i Another sobering stat is that the median 401(k) balance among workers age 55 or older is barely above $80,000.ii For many people, that will not fund an adequate retirement. It is not so much about maxing out a 401(k) but simply focusing on saving more, having financial flexibility, and minimizing taxes over the long haul.

A Dynamic Approach to 401(k) Saving

What’s great about employer-sponsored retirement plans is that you have flexibility at all times. Most workers can adjust their contribution amount (either a percentage of salary or a dollar figure) at any time. Another trick that works well to help you save more is to increase your deferral amount bit by bit – there’s a common feature known as the “auto-increase” or “auto-escalation” that increases your contribution amount without you having to lift a finger after you have set it up. You could establish that on the first of the year to go along with when you get your yearly pay raise.

Bigger Picture

Finally, it is not all about building your net worth. A good financial plan includes items such as a formal estate plan (a living will, advance health care directive, and trust accounts), health and disability insurance, and a plan for long-term care needs should those arise.

The Bottom Line

Prioritizing other financial goals and saving strategies ahead of maxing out your 401(k) is often a good decision. While some high-income workers should think about reducing their tax bill today to fund their retirement, not everyone should feel like they must contribute the highest amount possible to a 401(k). You should weigh the pros and cons if you were to do so along with possible risks between now and the start of your retirement.